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Abstract:
In this paper we show that, when the firm's opportunity rate of reinvestment is different from its financing rate, the risk-adjusted discount rate method (RADR) of computing Net Present Value (NPV) leads to the same type of incorrect results that required new methodology for modifying Internal Rate of Return (IRR) calculations (i.e. Modified Internal Rate of Return (MIRR)). Specifically, the current method of calculating NPV is biased in favor of (against) high-risk projects and against (in favor of) low-risk projects when the risk-adjusted discount rate is greater (less) than the firm's average marginal cost of capital (WACC) for two reasons. First, it incorrectly assumes that the reinvestment rate for project cash inflows is the risk-adjusted discount rate of the project instead of the firm's opportunity rate of reinvestment. Second, it incorrectly assumes that projected cash outflows, for the time periods after the initial outlay, are also discounted at the risk-adjusted discount rate. We propose a new methodology to establish a Modified NPV (MNPV) to eliminate the RADR methodology bias and derive a generalized rate of return (k*) under all combinations of reinvestment and financing rates for a firm. In addition we derive and demonstrate the linkages and consistency between the new MNPV, k*, Profitability Index (PI) and MIRR methodologies.
(ProQuest: ... denotes formulae omitted.)
Introduction
The Net Present Value (NPV) and the Internal Rate of Return (IRR) are two of the most widely used techniques in capital budgeting decision making. The problems of IRR have been widely investigated and various modified internal rate of return (MIRR) models were devised as an alternative measure of rate of return and addresses many of the shortcomings of IRR (see Lin 1976; McDaniel, McCarty and Jessell 1988, and Beaves 1988 and 1993). On the other hand, the major criticism of NPV to date has been its failure to take into account the managerial option to abandon or extend a project and hence the NPV method underestimating the true NPV of the projects cash flow. Many of today's corporate finance textbooks already addressed these issues and many have integrated the application of options theory to capital budgeting problem (e.g. Pinches 1994 and Van Horne 1995). The interaction of financing and investment decisions has also been addressed by...